11.12.2014 Clearing Up the Confusion Surrounding Stress Testing

When it comes to the expectations of the financial regulators with regard to loan portfolio stress testing, community bankers can be forgiven if they sometimes get a little confused. Dodd-Frank doesn’t require community banks with $10 billion or less in assets to stress test their portfolios, but regulators have made it clear that they think it would be a very good idea.

Fortunately, the OCC has provided some regulatory guidance to try to help clear up the confusion. The OCC published Community Bank Stress Testing: Supervisory Guidance (Bulletin OCC 2012-33) to help community banks determine the best way to use stress testing to spot and quantify portfolio risk.

What the Bulletin Says

In a nutshell, the bulletin states that some form of annual portfolio stress testing or sensitivity analysis is critical to sound risk management for any bank, including community banks smaller than $10 billion. And stress testing should be performed on the entire portfolio, not just on individual loans, according to the bulletin.

The regulators expect all banks, regardless of size, to have a plan in place for how they will maintain adequate capital levels, in addition to effective internal processes for assessing capital adequacy as it relates to overall risk. They believe that stress testing is the best way for community banks to find out where they’re vulnerable to market forces and determine how they will manage these risks.

This regulatory guidance goes beyond stress testing for interest rates to include stress testing for other adverse market factors that can affect commercial real estate (CRE) loans and acquisition, development and construction (ADC) loans. These factors could include falling rents, slowing absorption rates, rising cap rates, and higher operating expenses for property owners.

The OCC bulletin gives community banks some leeway in terms of deciding which of these and other market factors they should test for. “A community bank’s approach to stress testing should fit its unique loan portfolio strategy, size, loan types, composition, operations, and management,” it states.

Types of Stress Testing

While the bulletin doesn’t endorse any specific stress testing method, it does point out that the stress testing methods used by community banks can be less complex than those used by large banks.

Here are four stress testing methods noted by the bulletin that are commonly used by community banks:

  1. Transaction — Gauges the potential impact of changing economic conditions on the ability of individual borrowers to service debt, and uses this to estimate potential loan losses.
  2. Portfolio — Gauges the potential impact of changing economic conditions on the financial performance of borrowers, and uses this to help spot portfolio risks (both current and future).
  3. Enterprise-level — Gauges how different types of risk and their interrelated effects might impact the bank assuming different economic scenarios.
  4. Reverse — Postulates what types of events and scenarios could lead to possible adverse outcomes.

Regardless of which method is used, the OCC bulletin includes several things that are common to all effective stress tests. These include the use of “what if” questions as they relate to specific bank vulnerabilities and making reasonable determinations of the impact a market factor could have on capital and earnings. Also, the test’s results should be incorporated into the bank’s overall risk management process, the bulletin states.

11.12.2014 Keeping an Eye On Internet Lending

A new type of consumer and small business lending has popped up over the past couple of years that many lenders are just now becoming aware of. Internet-based lending platforms are connecting lenders and borrowers virtually, thus enabling borrowers to bypass traditional banks for many types of consumer and small business loans.

These Internet-based loans are usually referred to as peer-to-peer loans, cloud funding or crowdfunding. While Internet loans represent just a tiny fraction of overall lending volume in the U.S. now, it’s worth keeping an eye on as its popularity as an alternative to traditional lending continues to rise.

The Lowdown on Internet Lending

Peer-to-peer lenders are mostly individual investors looking to earn healthy returns on their money. LendingClub.com and Prosper.com are two of the biggest peer-to-peer lending websites right now. Crowdfunding investors are often the family members and friends of entrepreneurs looking to raise money for new startup ventures. IndieGoGo.com, Kickstarter.com and Kiva.com are among the most popular crowd-funding websites today.

Cloud lenders focus primarily on making small business loans up to $100,000. OnDeck and Kabbage are two of the biggest sources of cloud funding. In just seven years, OnDeck has become one of the largest small business lenders in the U.S., lending over $1 billion to more than 20,000 small businesses in every state. The lender has developed a proprietary credit scoring model that it uses to make decisions on small business loan applications in a matter of minutes, based on the information borrowers provide in a simple online loan application that takes less than 10 minutes to complete.

Kabbage specializes in lending to online merchants and e-commerce businesses — their loan review process looks at the merchant’s online transaction history, user feedback ratings and even social media activity, along with its business credit score. Once approved, borrowers can access their funds immediately via PayPal.

Advantages and Drawbacks

The biggest benefits of Internet lending to borrowers are the ease of application and relatively high loan approval rates compared to bank consumer and small business loans. Specific loan approval rates vary among different Internet lending platforms, but in general, it’s easier to get a loan from a peer-to-peer or cloud lender or via crowdfunding than it is from a traditional bank.

But this ease of application and approval does come at a cost. The interest rate on small business cloud loans is generally higher than on bank small business loans. Interest rates on consumer peer-to-peer loans vary widely — they can be higher or lower than bank consumer loans, depending on many different factors.

Crowdfunding, meanwhile, is a little bit different from peer-to-peer lending and cloud funding. Most crowdfunding lenders aren’t looking to earn high rates of return on their money; rather, they just want to help entrepreneurs raise money to start a new business venture or launch a new product or service. Also, borrowers raising money via crowdfunding typically must raise 100 percent of their requested amount in order to receive funding — if they fall short, they don’t get any money.

If you are involved in the lending industry, it’s probably smart to keep Internet lending on your radar. It will be interesting to see how it fares in the coming years as traditional bank lending continues to search for its footing.